Buying on margin lets investors borrow some of the money they need to buy stocks. If you want to increase the potential return on a stock investment, you can leverage your purchase by buying on margin. That means borrowing up to half of the purchase price from your broker.
Your goal is to sell the stock at a higher price than you paid, so you can repay the loan, plus interest and commission, and keep the profit. But if the stock loses value, you still have to repay the loan, so your losses could be larger than if you had owned the stock outright.
You set up a margin account with a broker and transfer the required minimum in cash or securities to the account. Then you can borrow up to 50% of a stock's price and buy with the combined funds.
For example, if you buy 1,000 shares at $8 a share, your total cost would be $8,000. But buying on margin, you put up $4,000 and borrow the remaining $4,000. If you sell when the stock price rises to $12, you get $12,000. You repay the $4,000 and keep the $8,000 balance (minus interest and commission). That's almost a 100% profit. Had you paid the full $8,000 with your own money, you would have made a 50% profit, or $4,000.
Despite its potential rewards, buying on margin can be very risky.
For example, the value of the stock you buy could drop so much that selling it wouldn't raise enough to repay the loan. To protect brokerage firms from losses, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) require you to maintain a margin account balance of at least 75% of the purchase price of any stock you buy through the account, or an additional 25% above the 50% you borrow.
Individual firms can require a higher margin level, but not a lower one. If the market value of your investment falls below their required minimum, the firm issues a margin call.
You must either meet the call by adding money to your account to bring it up to the required minimum, or sell the stock, pay back the broker in full and take the loss.
For example, if shares you bought for $10,000 declined to $6,500, the shares would now be worth only 65% of their value when you purchased them. If your broker has set a 75% margin requirement, you would have to add $1,000 to bring your margin account up to $7,500 (75% of ,000).
During crashes, or dramatic price decreases in the market, investors who are heavily leveraged because they've bought on margin can't meet their margin calls. The result is panic selling to raise cash, and further declines in the market. That's one reason the Federal Reserve Board instituted Regulation T, which limits the leveraged portion of any margin purchase to 50%.
To open a margin account, you must deposit a minimum of $2,000 in cash or eligible securities (securities your broker considers valuable). All margin trades have to be conducted through that account, combining your own money and money borrowed from your broker.
Leverage is speculation. It means investing with money borrowed at a fixed rate of interest in the hope of earning a greater rate of return. Like the lever, the simple machine for which it is named, leverage lets the users exert a lot of financial power with a small amount of their own cash. Companies use leverage - called trading on equity - when they issue both stocks and bonds.
Their earnings per share may increase because they've expanded operations with the money raised by bonds. But they must use some of those earnings to repay the interest on the bonds.
Processing your request...
This may take a few moments...